The Fully Amortizing Mortgage and Savings Discipline

February 7, 2005, Reviewed July 9, 2007, May 1, 2011

“The equity from sale of our old house will cover the first 6 months of payments on the new one. To avoid spending this money, we plan to make 6 payments immediately, then we have 6 months to save enough from our current income to repeat the process. Is this a wise strategy?"

You are attempting to impose a savings discipline on yourself, which is admirable. The cost is the interest that you would otherwise earn on the money that you send to the lender early.

In itself, the lost interest is not a compelling argument against your plan. Savings discipline is a value that many people the world over are willing to pay well for, as I’ll illustrate shortly. The argument against your plan is that it won’t be very effective.

A Forced Saving Plan That Won't Work

Putting a sum equal to 6 months of payments beyond the reach of temptation will work, but your plan breaks down in phase 2. Having made the first 6 months of payments in month 1, you now have to save another 6 months of payments during months 1-6, with no payments due until month 7. Without the prod of an imminent required payment, you are subjecting yourself to less discipline rather than more.

I suggest you invest your existing nest egg in a form that discourages early redemption, such as a larger down payment or a deferred annuity. Then subject yourself to the discipline imposed by having to make a monthly payment, on-time, each and every month.

Fully Amortizing Mortgage Promote Savings Discipline

The fact is that the fully-amortizing mortgage is the best instrument ever invented for promoting savings discipline. The payment you are contractually obliged to make every month has a savings component – it is the portion of the payment that is allocated to principal. This piece of the payment gets larger every month as the interest portion gets smaller, until the loan is finally paid off.

People without access to fully amortizing mortgages come up with numerous techniques for imposing savings discipline on themselves. Some of them are quite costly.

Costly Forced Savings Devices

When I was in Liberia, for example, I noted that many people saved for a house by purchasing cinder blocks, which they piled up on their land until they had enough to start building. Not only did they lose the interest that would have been earned had their savings been deposited in a bank, but their cinder blocks also deteriorated in bad weather. Nonetheless, there was no secondary market in cinder blocks, so they were protected against any sudden impulse to spend their savings.

In another costly forced saving practice that is widespread in developing countries, a group of like-minded persons commit themselves to contribute a certain amount every month to their informal association. In Africa, these are called ekub or susu. One of the group, usually chosen by lottery, gets the full amount every month. If there are 12 members contributing $100, for example, each member receives $1200 at some point during the year. The risk, of course, is that those who get theirs early will decide to get lost.

Costly forced savings practices are not limited to developing countries. In the US, millions of taxpayers – mostly lower tax-bracket non-homeowners – deliberately over-withhold on their income taxes so they can get a refund at the end of the year. They usually realize they are giving an interest-free loan to the Government, but they don’t care. The practice is so widespread in the military that the legal assistance department of the adjutant general’s office sends out warnings not to do it, but to no avail.

Savings Discipline Continually Weakens in the US

This provides a useful perspective on recent trends in the US toward weakening the savings discipline provided by the amortized mortgage. For a small increase in the price, a borrower today can switch from an amortized mortgage into an interest-only mortgage that doesn’t amortize for 5 or 10 years. The borrower who takes an interest-only mortgage pays to avoid savings discipline, which so many others throughout the world pay to receive.

Savings discipline is also undermined by the ready availability of home equity lines and credit cards. Don’t get me wrong, these are useful options, but useful options that appeal to the weaker part of our nature are often misused. Many of the people who write me after they get into trouble -- who unfortunately outnumber those who write me on how to avoid trouble -- are in trouble because they could not resist temptation. Our system is rich in financial gadgets for avoiding savings discipline, and poor in gadgets for promoting it.

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